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Investing Basics

Resources: Investing Basics: Risk

What is Risk?

Risk is the probability, based on historical data, that the value of an asset will increase or decrease. Risk is inherent in all investments, but it can be reduced when viewed in conjunction with the expected return. Accepting a high level of risk generally goes along with seeking a high return on an investment, while accepting a lower level of return is seen to reduce the amount of risk involved.

There are numerous risks associated with owning financial instruments. Academics have noted some 30 distinct types of risk that can affect a financial instrument or the market as a whole. Some of the most common include the following:

  • Interest rate risk - Fixed-rate instruments can decline in value when interest rates rise.
  • Inflation risk - Relative income or the value of assets will fall as inflation increases. This is more pronounced with fixed-income instruments.
  • Exchange risk - Foreign currencies fluctuate in price, which can increase or decrease their value. For instance, when a foreign currency increases in value, it can make imports more expensive.
  • Repayment risk - Borrowers or creditors can fail to make a payment by the specified date.
  • Liquidity risk - The risk that arises from the difficulty of selling an asset at what might be considered its "true value."
  • Inventory risk - Danger that the value of inventory will decrease due to product obsolescence or damage.

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What are the risks of investing in stocks?

While these risks can affect any market, the risks most often associated with stock purchases have to do with both general market and company-specific risks. These risks are also called systematic and non-systematic risk by academics.

  • Market (systematic) risk
    This risk occurs when the entire stock market drops in value. This can happen when economic conditions, international events, tax policy or interest rates change. International stocks face additional risks, including changes in currency exchange rates, political instability or inconsistent accounting and reporting methods.
  • Business (non-systematic) risk
    This is the risk that a company's stock price will drop because of poor business conditions that are specific to the company or its industry. For instance, a company could perform poorly because its products are less popular than competitors' products, because of management, regulatory changes or foreign competition. A company could also perform poorly because sales or profits in its entire industry are down.

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What are the risks of investing in bonds?

Fixed-income instruments are especially affected by interest rate movements, changes in the credit quality of the bond issuer, and pre-payment risk. If you invest in bonds, you'll face these kinds of risk:

  • Credit risk
    This is the risk that the bond issuer won't be able to pay interest and/or repay your principal. The credit quality of a bond is often rated by independent rating agencies. For instance, bonds rated AAA, AA, A or BBB by Standard & Poor's are considered "investment grade" and have relatively low risk, while bonds rated lower than BBB have a higher risk of default. The highest risk bonds are commonly referred to as "junk bonds" and usually offer higher interest rates to compensate for their risk.
  • Interest rate risk
    This is the risk that the value of a bond will rise or fall as interest rates change. Bond prices generally move in the opposite direction of interest rates. For each percent that interest rates rise or fall, a bond's value will typically decrease or increase a percentage equal to the bond's duration. For example, a bond with a duration of five years could decline in value by five percent if interest rates rise by one percent. Therefore, fluctuations in interest rates have a greater impact on bonds that have the longest maturity (the length of time until the bond is repaid in full) and duration.

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Easy ways to minimize risk

Stocks and bonds both offer investors good opportunities for medium- to long-term investment returns. Whether they're good investments for you depends on several factors, including your goals, tolerance for risk and time horizon.

In general, the greater an investment's potential returns, the greater the risk involved. Understanding your tolerance for risk and your financial goals will help you choose investments that are right for you and help manage your risk.

Here are some more tips for helping to reduce risk when you invest:

  • Buy and hold.
    Because some stock prices tend to move up and down quickly, they may involve a good deal of short-term risk. But the historical long-term trend of the stock market has been upward (this refers to the overall trend of the U.S. market, from its beginnings until now), so you may decrease your risk if you're willing to leave your money in stocks for years.
  • Make use of mutual funds.
    By pooling your money with other investors in mutual funds, you can indirectly own a variety of stocks and bonds, spreading your risk through different investments.

    Once you find a mutual fund that matches your investing goals, a professional fund management team does the work. Professional fund managers monitor the fund's holdings and performance, using in-depth research and analysis to investigate new opportunities to meet the fund's goals.

  • Develop a taste for dollar cost averaging.
    Dollar cost averaging is a technique of buying the same dollar amount of an investment on a regular basis, such as once a month. This reduces the risk that you'll buy all your shares of the investment at its highest price. It also potentially lowers the average price you pay per share since you'll buy fewer shares when the price is high and more shares when the price is low.

    Dollar cost averaging does not assure a profit or protect against loss. Investors should weigh their ability to sustain investments during periods of market downturns.

  • Allocate your assets.
    When you use asset allocation, you allot a percentage of your investments to each major asset class (stocks, bonds and cash equivalents), based on your personal investment profile. This scientific, methodical approach helps you reduce risk by diversifying your assets - so, once again, you aren't leaving all your eggs in one basket. The goal is to get the highest returns possible at the level of risk with which you're comfortable.
  • Get expert input.
    A financial professional can help you decide which investments are right for you and help you minimize risks when you invest. To learn more, read Working with a Financial Professional.

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